Hello friends. In this blog, we discuss various financial topics. That is why we have launched the ‘Stock Market Terms’ series. This is the fifth post of that series. The topic of our discussion in today’s post is Return on Equity. In the previous post, we discussed “Price to Earnings Growth Ratio“.
What is Return on Equity (ROE)?
Return on Equity is the measurement of a company’s return generated from the invested amount of its equity shareholders. ROE is often considered as the tool to get the idea about the efficiency of a company to utilize its limited capital. In general, a good company generates good profit from a limited amount of capital. Hence, its ROE becomes higher. On the other hand, a poor company cannot utilize its capital properly and in return generates very small or negative profit. This in turn results in poor ROE.
The formula of Return on Equity
The formula of Return on Equity is as below.
ROE = (Net profit of the company/Shareholder’s Equity)
Types of Return on Equity
There are two types of ROE depending upon the type of shareholders. One is Return on Common Shareholder’s Equity and the other is Return on Preferred Equity. In the case of preferred equity, the company is obliged to give the preferred equity shareholders a guaranteed percentage of return.
How to calculate ROE of a company – With Example
While we calculate the ROE of a company, generally we do it for the common shareholders. Hence, the ROE can be calculated like this –
Example 1 – For ITC the net profit of the company at the end of 31.03.21 is 13,031.64 and shareholder’s equity is 59,004.58. Hence, ROE is (13,031.64/59,004.58) = 22%.
Example 2 – For Hindustan Uniliver the net profit of the company at the end of 31.03.21 is 7954 and shareholder’s equity is 47,674.00. Hence, ROE is (7954/47674) = 16%.
Example 3 – For Dabur the net profit of the company at the end of 31.03.21 is 1381.89 and shareholder’s equity is 5391.22. Hence, ROE is (1381.89/5391.22) = 25%.
Usage of ROE
ROE gives a good insight into the company’s management. It tells us whether a company’s management is efficient enough to utilize its shareholders’ equity properly and can earn a good return or not. For example, if a company is showing ROE of more than 15%, we can say that its management is utilizing the capital very well (as index Mutual Funds give returns around 15%). Let us understand this with an example –
Let’s say there are two companies – X and Y.
|Company||Share Capital||Net Profit||ROE|
This shows that even company Y has more capital than company X, it is not profitable as company X. Just by looking at the ROE, we can know this.
Drawbacks of ROE
ROE only includes the capital of its equity shareholders. However, there are other ways for raising capital viz. Debt and many companies manipulate their balance sheet to generate higher ROE so that just by seeing higher ROE investors put their money in that company. Let us see, how they do this.
Let’s say, In 2021, company A has common shareholders equity of Rs. 1 crore, Net profit is 5 lakh. Hence, ROE = (5/100) = 5%. In 2022, company A reduced its common shareholders’ equity to Rs. 60 lakh, Debt raised by the company is 40 lakh (@ 15% interest per annum), and Net profit is 9 lakh. Now, as the company has taken a loan, it has to pay the interest. Hence, its net profit in 2022 is = (12-6) = 6 lakh (after paying interest). Hence, its ROE in 2022 is = (6/60) = 10%. In 2022, company A’s ROE becomes double, however, it raised a loan of 40 lakh, the interest of which it has to pay every year even if does not generate profit. In poor economic conditions, companies with debt suffer heavily. So, here we can see that ROE can also misguide an investor. Further, ROE is not very useful in capital-intensive industries like Mining, Real Estate, etc. In these cases, we should use ROCE in turn of ROE. Further, one should check a minimum of five years of ROE of a company to get a clear picture.
Though ROE is probably the best financial ratio for investing, still an investor should check all the other parameters before investing in a company.
Hopefully, I’ve been able to give you a clear idea about ROE. Follow us to know all such information about various financial topics and to understand everything in simple language. If you have any questions about this post, please let us know in the comments or mail us at [email protected]. Share this article with others if you found it worthy. In this blog, we publish various articles on finance. To get all the post notifications from this blog, click on the red bell icon on the right side and turn on the notification. Thank you for spending your precious time reading this article. Stay well, stay healthy.